I’m fascinated by this huge article in the Washington Post called The Beautiful Machine. Its about AIG’s Financial Products divisions, a hugely profitable operation specializing in derivatives, with roots in Drexel Burnham, that traces its AIG affiliation all the back to 1987.

Its the first of three parts, and I’ll pull excerpts from each. Here’s Monday’s:

“Over the past two decades, their enterprise, AIG Financial Products, evolved into an indispensable aid to such investment banks as Goldman Sachs and Merrill Lynch, as well as governments, municipalities and corporations around the world. The firm developed innovative solutions for its clients, including new methods to free up cash, get rid of debt and guard against rising interest rates or currency fluctuations.

Financial Products unleashed techniques that others on Wall Street rushed to emulate, creating vast, interlocking deals that bound together financial institutions in ways that no one fully understood and contributed to the demise of its parent company as a private enterprise. In the panic of mid-September’s crash, the Bush administration said that AIG had grown too intertwined with the global economy to fail and made the extraordinary decision to take over the reeling giant. The bailout stands at $152 billion and counting — almost 10 times as large as the rescue for the American auto industry.

Many of the most compelling aspects of the economic cataclysm can be seen through the story of AIG and its Financial Products unit: the failure of credit-rating firms, the absence of meaningful federal regulation, the mistaken belief that private contracts did not pose systemic risk, the veneration of computer models and quantitative analysis.

At the end, though, the story of Financial Products is not about math and financial formulas. It is a parable about people who thought they could outwit competitors and market forces alike, and who behaved as though they were uniquely positioned to sidestep the disasters that had destroyed so many financial dreams before them.”

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

It is a parable about people who thought they could outwit competitors and market forces alike, and who behaved as though they were uniquely positioned to sidestep the disasters that had destroyed so many financial dreams before them.

I agree completely. But to complete the picture I would also recommend:

Nassim Nicholas Taleb–”The Black Swan”

Kevin Phillips–”Wealth and Democracy”

Jacob S. Hacker–”The Great Risk Shift”

None of this happened purely by accident. It was a huge fraud perpetrated on the American people and on the world, and the outcome was all but predictable. Mandelbrot is a wonderful read, but he is blind to, or chooses to ignore, the greed and perfidy that lurks in the heart of man.

This quote from the Washington Post story encapsulates the intent and spirit of the big fraud:

“But even as Financial Products experimented, Savage said, he continued to stress the need to minimize risk. ‘That was one of the things that really marked this company, was the rigor with which it looked at the business of trading. . . . There was an academic rigor to it that very few companies match,’ he said.”

What these con men did was to invent a pseudo-mathematics and a pseudo-science to make the risk appear less than what it really was. That was the only way they could hoodwink people into putting their money into things that were inherently risky, obfuscating the risk with their bogus mathematics and bogus science.

One has to wonder if appropriate firewalls between trading desks and I-Bank subsidiary mortgage servicers were effectively in place. Given epidemic mortgage servicing fraud, these CDS bets shorting ABX subprime index would appear to be no more than rigged bets. Was AIG schnookered by I-Banks or were they somehow complicit?

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About Barry Ritholtz

Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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